A Stock Portfolio Isn't a Retirement Plan (Do This Instead)

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This week's newsletter is an adaptation from my recent YouTube video on The Retirement Mentality Shift

The goal of investing is to accumulate wealth, as much wealth as possible.

However, that is not the goal of retirement.

In retirement, the goal is to utilize your wealth in order to live the best life possible, and too often, people do not realize that they are in a position where these two different mentalities are actually at war against each other.

In this week’s Five Minute Money, we will talk about the mentality shift that is critical to a successful retirement, and will cover 6 common mistakes retirees make, as well as provide a full framework for thinking about retirement.

Let’s begin.

The Mentality Shift.

There’s a high chance that you as a reader of this is a very good saver.

You have probably loved watching your income exceed your expenses to create savings, putting that into your investment account, and watching that number grow and grow, at the fastest rate possible.

This is something you kind of need to abandon when thinking about retirement, because the shift in mindset is no longer about total returns.

Instead, you want to move toward thinking about a wider probability distribution of outcomes, which often means giving up returns.

In layman's terms, that might mean having a larger portion of your assets in safe fixed income rather than putting assets in riskier stocks, because at this point, what matters is not making more money, but preparing yourself for a variety of different return scenarios.

Volatility all of a sudden is working against you.

When you invest in the stock market, volatility is not really a risk for a stock market investor, but there is always an asterisk to that: that is true if you can actually invest the money for the long term.

In retirement, you are actively pulling money out of your portfolio, so you cannot be a long-term investor to the same degree.

Volatility may have worked well for you throughout your investment career because it allowed more attractive entry points, but now it is something that could work against you, because bad returns early on could mess up your entire retirement plan.

That brings us to the second aspect, the sequence of returns.

Sequence of Returns.

The crux of this idea is that bad returns initially in retirement have a disproportionately negative effect compared to bad returns later in retirement.

The big risk is that you retire, and the next several years of stock market returns are bad.

Maybe it is a lost decade, which has happened several times in the past century, so your investment portfolio is not growing, while at the same time you are pulling money out of it.

In that scenario, you are at a much higher likelihood of actually running out of money.

Standard financial planning advice points to the 4% rule: you withdraw 4% of your portfolio's initial value, then adjust that amount for inflation every year, and in the vast majority of circumstances that will give you enough money to last 30 years.

But when we tested the 4% rule, it worked in about 97% to 98% of all return scenarios, using some fairly punitive assumptions.

If, instead, you get the worst quartile of returns across those simulations, you actually have a 13% chance of running out of money, 4 times higher than the overall odds.

That is the key risk: you may have skipped the proper mentality shift, kept optimizing for total returns with an aggressive stock portfolio, and it ends up shooting you in the foot, because you get a bad sequence of returns while pulling money out to live on, and you never get to enjoy those stocks potentially rebounding.

You end up worse off and at higher risk of running out of money.

This is why the mentality shift matters.

Stop focusing on the absolute highest possible return, the last dollar of return, and focus instead on safety and on what the money is actually there to serve.

It is there to help you build a life, so do not give up that life just to get a little more money you may not even know how to spend.

There is a third aspect to be aware of, your retirement spending pattern.

Your Retirement Spending Pattern.

It is very common for retirees, when they first retire, to spend more money than they initially expected.

A simple way to estimate retirement spending is to take someone's current expenses, add in new expenses like travel or medical costs, and subtract expenses they will no longer have, like supporting kids.

That gives a rough approximation good enough for early-stage planning, but as you get closer to retirement, you should understand that there will probably be stages to your spending.

Initially, you will likely spend more than expected, because when you first retire there are all these things you want to do, you are free from your job, you have all this time, and you are still in good health.

That is a smart thing to do, because by the time you retire in your 60s, you do not want to save all of the spending and travel until you are in your 80s, potentially in worse health and less mobile.

Instead, you want to lean into spending early if it is something you have always wanted to do, whether that is travel or new hobbies.

From a purely financial perspective, we know that spending more early sets you up a little worse later on, except the point of money is to serve you; that is the whole reason you were saving it in the first place.

This comes back to the mentality shift: if you are 65 and retired and telling yourself you will wait a little longer to take that vacation so your money can compound more and you can feel safer, that is probably a mistake if you are in a position to do it.

You should not be overly conservative with your wealth, and in another sense, you should not be underly conservative with your health, because you never know how long you will keep feeling great.

The typical spending pattern is that you spend a bit more initially, with a lot of travel, then dip a little as you become less mobile and have already checked off most of the bucket list, and then a third stage where spending kicks back up because of home care and medical expenses that tend to rise toward the end of life.

All of this should factor into how much you spend and your spending cadence, and it also connects to how you manage your account situation, which brings us to the fourth aspect.

Account Flexibility.

If you were saving throughout your working years, you have hopefully learned to diversify where you save your money: maybe a pre-tax 401, maybe a Roth IRA or Roth 401, maybe an HSA, and an individual brokerage account.

All of this lets you better control your income, because it is easy to forget that money pulled from a 401 or IRA in retirement is a taxable event; a pre-tax 401 balance of $1.5 million, for instance, is entirely taxable as you withdraw it.

Having multiple account types lets you control your income.

Maybe you also have dividend income from your portfolio, or some ancillary income, since it is common for people to partially retire rather than fully retire, in which case that income window could be a good time to pull from post-tax accounts.

Later, once you are not working and your income is zero, you could pull more from pre-tax accounts, playing this sort of game with where your income comes from in order to manage your overall tax liability.

There is a fifth thing that also provides flexibility, when you take Social Security.

When to Take Social Security.

If you search for the best time to take Social Security to get the most money out of it, you will usually see advice to defer it, maybe until age 70, with the reasoning that as long as you live past around 81, deferring is a net-present-value positive decision, meaning you end up with more money as a result.

That advice is missing a couple of important things.

First, it makes a fairly ambitious assumption about your longevity based on actuarial averages.

More importantly, though, if you are not taking Social Security, that income has to come from somewhere, which means drawing down your portfolio and giving up the investment returns that money would have otherwise earned, the opportunity cost.

So the decision of when to take Social Security should be considered in the context of everything else discussed here, including how much you are pulling from different retirement sources, since Social Security income is itself taxable.

It also makes sense to stay flexible with that decision based on market returns: if the stock market has been weak, there is a stronger case for taking Social Security so you can leave your portfolio alone to recover, taking some of the burden off it to provide regular income.

You Are Probably Underspending.

In most scenarios, it is quite likely that you have actually saved more money than you will need to live on, meaning you could potentially spend more.

When we ran a Monte Carlo simulation 10,000 times on our own version of the 4% rule, testing how much money a retiree could pull from their account across a variety of return scenarios, we found that in about 89% of scenarios, retirees could have employed a 5% rule instead of a 4% rule, 25% more spending in 89% of scenarios.

Still, this is all a probabilistic distribution, and while the 4% rule has gotten criticism lately for being overly conservative, it is worth remembering that the very high historical returns of recent decades cannot necessarily be counted on going forward.

Conservatism should be balanced against what the money is actually buying you.

If spending a bit more means two more trips a year and more time with your kids, that could be money well spent; if it just means buying a second sports car, a bit more conservatism is reasonable.

What tends to make the most sense is dynamic spending, adjusting how much you spend based on your portfolio's actual stock market performance and returns, continually recalibrated as conditions change.

Closing Thoughts.

If you are still in the accumulation phase and saving money, that is great, and there are still things you can do to better set yourself up for retirement, though that was not the focus of this post.

The focus here is making sure you really understand the mentality shift that happens once you are in retirement, moving away from chasing the highest possible return and toward thinking about what the money is actually going to provide you and the life it is going to give you, because that was the point of it all along.

Think about how this money can serve you.

If you have been worrying about money your whole life and you are now at a point where you no longer need to, it is a worse quality of life to keep carrying the old accumulator mentality into retirement, and that is one of the biggest mentality shifts you can make.

For more on the Retirement Mentality Shift, check out the video below.

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